Quarterly Review, June 2009

The BIS Quarterly Review released today is divided into two parts. The first presents an overview of recent developments in financial markets, before turning in more detail to highlights from the latest BIS data on international banking and financial activity. The second part presents two special feature articles, one on government debt management at low interest rates, and the other on the financial impact of the global crisis on Latin America and policy responses.

Glimmers of hope that the worst of the financial crisis and economic downturn had passed sparked a rebound in risk appetite among investors in the period between end-February and end-May. As a result, equity prices gained sharply, credit spreads narrowed and implied volatilities fell. This budding optimism emerged even as key economic indicators remained at depressed levels. Investors focused instead on incipient signs that economic conditions were deteriorating less rapidly than before, while intensified policy actions to counter the crisis and better than expected earnings announcements helped bolster confidence.

A number of policy measures contributed importantly to the improvement in investor sentiment. The publication of details on US and UK bank rescue plans reduced uncertainty, as did the results of the bank stress tests administered by the US Federal Reserve. The latter led, in particular, to a narrowing of US bank credit spreads. Moreover, investors initially took heart from further fiscal stimulus packages and from the coordinated action announced following the April G20 summit.

In addition, central banks took further steps to ease monetary conditions. Apart from rate cuts - where still possible - a number of central banks announced new and unconventional measures, including expanded credit easing actions and purchases of large quantities of government bonds. While such measures initially led to a drop in treasury yields, long-term interest rates displayed a general upward trend during the period as rebounding risk appetite reduced the flight to safe government bonds. Growing concerns about mounting government debt added to the upward pressure on yields, in particular towards the end of the period under review. In parallel, long-horizon forward break-even inflation rates rose, possibly reflecting investors' worries about the long-term inflationary implications of the ongoing expansion of public sector commitments.

Despite the turnaround in markets, by end-May conditions in many market segments remained some way off the levels seen before the bankruptcy of Lehman Brothers in September 2008. This was the case in equity markets, where, even after the recent sharp rallies, most indices were still 20-30% below where they stood in mid-September. In credit markets, while spreads had narrowed considerably from the peaks reached in early 2009, they had in general not fully returned to their earlier levels. Sub-investment grade and sovereign CDS spreads, in particular, were still significantly higher. However, in interbank markets, where the most extreme dysfunctions were seen in the aftermath of the Lehman collapse, conditions continued to gradually improve, and by end-May key money market spreads had returned to pre-Lehman levels.

The latest BIS international banking statistics point to an unprecedented contraction in banks' international balance sheets during the fourth quarter of 2008, in the wake of the failure of Lehman Brothers. The decline in both interbank claims and claims on non-banks (particularly in the United States) reflected reduced lending, disposal of assets and writedowns. Banks trimmed their crossborder credit to emerging markets, but their local operations in many of these countries remained stable. Reporting banks' cross-border claims on all four emerging market regions decreased by $282 billion, with claims on Asia-Pacific dropping the most. By contrast, claims extended from their foreign offices to local residents in local currency remained stable overall and actually increased in many countries.

The most recent BIS derivatives statistics indicate that the first quarter of 2009 saw a continued but limited decline of activity on the international derivatives exchanges. Total turnover based on notional amounts decreased further, to $366 trillion from $380 trillion the previous quarter. While overall turnover in interest rate derivatives remained largely unchanged, equity derivatives turnover fell for all contract types, and trading in foreign exchange derivatives also slid.

According to the latest BIS semiannual OTC derivatives statistics, in the second half of 2008 the financial crisis resulted in a decline in the total notional amounts outstanding of OTC derivatives to $592 trillion as of end-December from $684 trillion six months earlier - the first such contraction since data collection began in 1998. Both foreign exchange and interest rate derivatives markets recorded their first significant downturns in activity, while credit default swap (CDS) markets continued to contract, with outstanding amounts decreasing by more than 25%.

The latest BIS international debt securities statistics show that borrowing in the international debt securities market increased in the first quarter of 2009, reflecting a gradual return of confidence. Against a background of significant gross issuance, net issuance increased to $670 billion, up from $519 billion the previous quarter. By nationality, borrowing via bonds and notes was dominated by the United States, with US borrowing surging to $252 billion after very limited issuance in previous quarters. In contrast, UK net issuance dropped from $285 billion to $90 billion.

Special features

Debt management can be used at low interest rates to lower bond yields, to provide bank assets and thereby help maintain broad money growth, or to save on interest payments. In their special feature, Robert McCauley of the BIS and Kazuo Ueda of the University of Tokyo discuss the complementarities and tensions between debt management and monetary policy. Reviewing the interaction of central bank purchases of government bonds and debt management in the United States in the 1930s and Japan in the last 10 years, the authors suggest the potential for using debt management to alter the duration of government debt in private hands was not fully exploited in either case.

The financial impact of the global crisis on Latin America has in some respects been less severe than in previous ones. In a special feature analysing the effects of the crisis and policy responses, Alejandro Jara, Ramon Moreno and Camilo Tovar of the BIS note that its smaller impact reflects in part the development of domestic bond markets and improved balance sheet positions of the economies in the region, which have allowed gross capital inflow reversals to be partially offset by reductions in gross capital outflows. In addition, the authors document that policy responses have helped to ease both external and domestic financial conditions. Nevertheless, considerable risks remain due to the ongoing economic downturn.